Hedge Funds have significantly reduced their net long positions, especially selling off shares of companies in the Russell 2000 Index. Clearly they’re worried about the direction of the world’s stock markets as concerns about Chinese stocks continue to swirl.

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Bull and Bear Index suggests fear

Bank of America Merrill Lynch has released the latest edition of their Hedge Fund Monitor. The firm reports that its Bull and Bear Index sits at 2.0 on a scale of 0 to 10, indicating a high level of fear.

Among the factors indicating fear is the fact that last week marked the fifth consecutive week in which hedge funds sold stocks. BAML also reports that institutional clients were also net sellers for the last five consecutive weeks, while private clients were net sellers for the last two weeks. The firm noted net sales were in large cap stocks.

Large spec hedge funds go shorter

Large speculative hedge funds increased their short positions in the S&P 500 and Russell 2000 indexes last week. They also cut their long positions in the NASDAQ 100, indicating that no stock is safe from this bearish pullback.

They were especially bearish on Russell 2000 stocks, dumping $4.05 billion worth of contracts on stocks in the index, marking the most in five years, according to BAML. Large speculative hedge funds also upped their overall short positioning to be net short $12.6 billion from their previous notional net short of $8.2 billion, including "E-minis and big contracts."

Hedge Funds

Overall, U.S. long/ short equity hedge funds were at 39% net long last week, which is within the benchmark of 25% to 40%. Since the previous week, BAML found that long/ short hedge funds' market exposure tumbled from 53% net long to 39% net long.

Hedge Funds

BAML reported that share repurchases by corporate clients in the U.S. also rose last week, hitting the highest level since May. They still remain lower than last year's levels when looking at four-week averages.

10-year Treasuries starting to look stretched

According to BAML, the 10-year U.S. Treasury note is at risk to fall below the 6-month channel support of 2.171%/ 2.14%. The firm's analysts note that the asset is one of the best-performing assets currently, but they think hedge funds' positioning in it is starting to look stretched. They say that large speculative funds recorded a net long of $22.2 billion in Treasuries, marking the highest level since April 2013.

U.S. investment grade funds had an outflow of $1.1 billion after 16 straight weeks of inflows, marking the highest weekly outflow for that class in about two years. BAML analysts don't read much into this data point, however, as "the magnitude is amplified by the technicalities around monthly vs. weekly reporting IG funds." Exchange-traded funds again drove the high-yield outflows, delivering $960 million of the outflows, with loan funds reporting $350 million in outflows.

The BAML team suggests that one of the main reasons the selloff in high yield funds "has been so painful" is because no sector is a clear leader. They suggest that the market needs a "purge" and a clear leader to emerge, although they don't think this is likely to happen.

"Outside of healthcare, fundamentals are uninspiring while innovation, for now, seems to have been replaced by capital preservation," the BAML analysts mused. "Capex is virtually non-existent, issuance has plummeted, and no sector has proven to be the one to make investors feel good about the space," they added.